When an Earn-Out Turns a Business Sale Into a Tax Dispute

The situation

Hua spent close to two decades building a group of quick-service restaurant locations around Peterborough, growing from a single franchise to several units before deciding it was time to retire. In 2024, he agreed to sell the entire operation to Yanni, an experienced multi-unit franchise owner from outside the region who was looking to expand his own portfolio. The deal closed at a total price of roughly $8,000,000. Of that, about $2,400,000 was structured as an earn-out — additional payments spread over the following three years, tied to how well the locations performed after the sale.

Earn-outs are common in business sales. They let a buyer defer part of the price until the business proves itself, and they let a seller capture upside if performance holds. Hua's general practice lawyer, who had handled his affairs for years, drafted the purchase agreement itself but flagged early on that the earn-out's tax treatment was outside his usual work and recommended Hua get tax advice before the numbers in the agreement were locked in. Hua brought the draft to our office a few weeks before closing. We reviewed the earn-out formula and advised on how it needed to be structured, and documented, to give the revenue-linked portion of the payments a real chance at capital gains treatment, separate from the portion tied to Hua staying available to help with the transition. Hua and Xia used the proceeds to retire comfortably, understanding going in that the revenue-linked tranche stood a good chance of capital gains treatment while the tranche tied to Hua's ongoing availability would likely be taxed as ordinary income regardless of how carefully it was drafted. They reported each payment on their returns the way we had advised, split between the two tranches, and the file went quiet for a long stretch after the first payment arrived on schedule. It did not occur to either of them that the same three-year window meant to give Yanni time to prove the business out was also a window during which the CRA could still take a close look at how the payments had actually played out in practice.

The tax problem

Nearly two years after closing, the Canada Revenue Agency reassessed Hua's tax returns for the years the earn-out payments were received. The CRA's position was that a meaningful portion of those payments should be treated as fully taxable business income rather than as part of the capital gain on the sale.

The CRA has a long-standing administrative approach that allows earn-out payments in a business sale to be treated as an addition to the sale price — and taxed as a capital gain — but only where specific conditions are met at the time the deal is struck. Broadly, the payments have to be genuinely tied to the value of the business itself, the amount of the eventual payout has to be something that could not reasonably be pinned down when the deal closed, and the arrangement generally has to run for a limited number of years. Where an earn-out instead functions as a disguised salary, bonus, or consulting fee for the seller's continued involvement, the CRA treats it as ordinary income, taxed in full.

Hua's earn-out agreement, on our advice, had kept the two elements in genuinely separate tranches on paper: one keyed strictly to store revenue, a second keyed to Hua remaining available for consultation and a smooth handover during the transition. But the contract's wording was not the whole story. During the transition period itself, emails between Hua and Yanni's operations team referred to his ongoing help in general terms, without distinguishing which tranche a given piece of advice or a given site visit related to. The CRA's auditor pulled that correspondence and argued that, whatever the contract said, the way the parties actually behaved after closing showed a single, undifferentiated consulting relationship rather than two distinct payment streams. Under a straight capital gains characterization, Hua would have included half of the $2,400,000 in income, taxed at roughly $640,000. Treated in full as ordinary income, the same amount would generate a tax bill closer to $1,280,000 — a difference of roughly $640,000 that the CRA was now pursuing.

What we did

1. Filed a notice of objection within the strict deadline. A reassessment can only be formally disputed within a limited window after it is issued, and missing that window forecloses the right to object at all, regardless of how strong the underlying facts are. That made it the first priority the moment the reassessment landed, ahead of gathering the fuller documentary record — a bare-bones objection preserving Hua's rights went in immediately, with the detailed argument to follow once we had it built.
2. Reconstructed the earn-out's real structure. We went back through the purchase agreement, our own file notes from advising on the drafting before signing, and Hua's correspondence with the buyer's side through negotiations and the transition period, to separate what the earn-out was actually compensating. Some of it clearly tracked the ongoing performance of the locations themselves — the kind of contingent pricing the CRA's own policy is meant to accommodate, and exactly what our original drafting had been built to support even though the later correspondence had muddied it.
3. Argued for a split characterization. Rather than defending the entire $2,400,000 as capital gain, we took the more defensible position that the portion tied to store revenue met the conditions for capital gains treatment, while the portion tied to Hua's continued availability did not. Conceding the weaker part of the claim gave the stronger part more credibility with the CRA appeals officer reviewing the file.
4. Negotiated directly with the CRA's appeals division. Objections are reviewed by an appeals officer independent of the auditor who issued the reassessment, which meant a genuine second look rather than the same person defending an earlier conclusion. We presented the split analysis with the supporting documentation directly to that officer, rather than letting the file default to the auditor's original all-or-nothing position by simply restating our disagreement in writing.
5. Advised on the realistic alternative. Hua could have pushed the dispute to the Tax Court of Canada rather than settling with the appeals officer. We laid out honestly what that would cost in time and legal fees, and what the odds looked like given how the earn-out had actually been drafted, so he could weigh a negotiated result against a court fight with no guaranteed outcome.

The outcome

The CRA appeals officer accepted the split characterization. Roughly $1,300,000 of the $2,400,000 earn-out was allowed capital gains treatment, consistent with the revenue-based portion of the formula. The remaining roughly $1,100,000, tied to Hua's post-sale availability, was confirmed as ordinary income. The net result was additional tax owing of about $290,000 above what Hua had originally reported — well below the roughly $640,000 the CRA had first sought, but a real and unavoidable cost.

That outcome showed both what the earlier planning had done and what it could never have done. Because the revenue-linked tranche had been drafted with the CRA's conditions in mind before closing, and kept genuinely distinct in the formula itself, that $1,300,000 held up as capital gains with comparatively little friction — there was little for an auditor to dispute in a clean, contemporaneously drafted number. The $1,100,000 the CRA held onto was never going to go differently no matter how the contract was worded: a tranche tied to a seller's continued personal availability is compensation for services in substance, and how the parties described it in emails after closing mattered more to the CRA than the label the contract gave it. The dispute and the professional fees to resolve it were a real cost of including a retention-style tranche in the deal at all — but the $290,000 in extra tax, not the roughly $640,000 originally at stake, was the actual price of having gotten the documentation right at signing.

Hua and Xia paid the reassessed amount from the sale proceeds still held in savings. It was not the retirement they had planned around, but it was a contained and known cost rather than an open-ended dispute heading toward court. Xia, who had handled the household's bookkeeping through the years Hua ran the restaurants, said afterward that the hardest part was not the dollar figure but realizing that even a contract drafted carefully in advance could still be undone, in the CRA's eyes, by how casually the transition-period emails described Hua's ongoing help. They still recommend Yanni to other operators looking to sell, and the two families remain on good terms — the dispute, in the end, was with the CRA, not with each other.

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